What is passive income?

Let’s start by talking about making money, or, your income.

There are two types of income — active and passive.

Active income is when you do work and are paid for that work. If you work at McDonald’s, you are paid for the hours you work. If you work in an office, you may not clock in and clock out but you are paid based on the work that you do. If you do nothing, you will no longer be paid.

Passive income is when the payment is not directly tied to active work. Interest and dividends are prime examples of passive income. Typical passive income sources are front-loaded with active work, for which you are paid a small amount, while the bulk of the income comes later.

It’s still working, it’s just that your income is not directly tied to the hours worked. Anyone who owns rental properties knows that it’s considered passive income but there is quite a bit of work involved. The work is front heavy but if you are lucky, you can collect rental checks without incident for many months before having to do work.

How does passive income accumulate wealth?

The key to accumulating wealth is uncomplicated:

1. Sell your time for money
2. Spend less than you earn
3. Invest your savings so it will grow without your active intervention.

That’s it. It’s a simple input and output problem. And it’s also what separates the rich and the wealthy. There is just one constraint on the whole system — your time in this world. You have just 2.21 billion heartbeats. At 60 beats per minute, that’s a little over 70 years. Each beat matters. You need to eat. You need a place to sleep. And both of those, and other needs, require money.

So in an ideal world, you could take your time to build a massively successful business (or maybe a few failures before the massive success), but in the real world, you need a job that will pay you now so you can feed yourself, clothe yourself, and secure a place to sleep.

Grow Your Active Income First

If you have no other resources, you start by focusing on active sources of income (job) until you’ve saved enough so that you can build up passive resources.

When it comes to the idea of saving money, there are two schools of thought:

• Save more — This school has you focus on living “frugal” and cutting your expenses to the bare minimum.
• Earn more — This school has you focus on earning more, on side hustles, businesses, etc.

It’s a false dichotomy. You can do both and you should do both.

The difference is that cutting expenses is immediate, much like active income is immediate, whereas earning more is often a long term play, like building sources of passive income. So you cut what you can now (e.g. cut your cable) and secure immediate savings while you build up your passive sources (e.g. put cable savings into dividend stocks).

The importance of saving money, especially early in your life, cannot be overstated.

When you start with nothing, or close to it, you are forced into active income. What you can save can be converted into passive income. If you don’t save that active income, through your own choices or choices thrust upon you, you will be stuck in that phase forever.

Many of those passive income sources, like qualified dividends and long term capital gains, also get extremely favorable tax treatment. If you’re in a low tax bracket, you may pay zero taxes on capital gains. If you are in a high tax bracket, it’s only 15% — far lower than ordinary income tax rates.

Then Grow Your Passive Income

I think of each passive stream as falling into one of two categories:

• You build something (business) that provides value and then capture some of that value.
• You lend money to someone who will build something of value and they pay you for that money.

In both cases, you need savings.

When you build a business, you’re giving up active income (instead of working for pay, I’m volunteering at my own business) for future active and passive income. In the meanwhile, you’ll need a way to pay for your expenses. It could be that you’re building a business on the side, so you still have a day job, or you’re living on those savings. Either way, you need a cushion.

When you lend money, you’re lending your savings to someone who will put in sweat equity to grow it into more.